A Short Course on Fundamental Analysis: Insights On Indicators

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By
Matt Blackman

April 1, 2010

Fredrik Broden

Whatever your investment or trade time frame, indicators are important. Active traders, who may operate with time frames of a few minutes or hours, tend to focus on the technicals to exploit small inefficiencies, often ignoring the underlying market and economic fundamentals. Long-term investors, on the other hand, prefer to overlook the daily intraday technical “noise” and focus on corporate and economic strengths (or weaknesses). For the active trader who falls somewhere in the middle, here are some fundamental indicators that can provide useful insights into the corporate and economic fundamentals.

Stock Indicators

At the risk of over-simplifying, there are three categories of fundamental stock indicators—the common, the less common, and the cryptic. Common indicators are those familiar to all investors that are used to evaluate whether a stock is fairly priced or not. At the top of the list is the price/earnings ratio.

Less common indicators include ratios such as price/sales, price/book, earnings per share (EPS), and price-earnings-growth (PEG).

Unfortunately, when it comes to fundamental indicators, all are lagging, since the data upon which they are based is historic. On the day that an earnings report is published, the data can be three months old or older. An indicator’s usefulness depends on how accurate it has been in the past. It’s based on the premise that although history may not repeat exactly, it can rhyme.

Before getting into the fundamental stock indicators more relevant to the active trader, let’s talk a little about that old favorite, the price/earnings ratio. While it may be one of the best-known indicators, it has challenges. How and over what period are earnings measured? And what do earnings include? For example, are they EBIT (earnings before interest and taxes) or EBITA (earnings before interest, taxes, and amortization)? Are the earnings TTM (trailing twelve months), TTY (trailing ten years), forward, or forecasted earnings? And there is always the possibility of some “fudging” in the mix based on various interpretations and applications of accounting rules—or worse.

PRICE/DIVIDEND RATIO. One useful indicator that seems to fall into the cryptic category (since it is not widely used) addresses some of the uncertainties of the P/E ratio. This is the price/dividend ratio. Stock price is established by the market, and either a company pays dividends or it doesn’t—there is far less potential for confusion or fudging the numbers if the company turns out to be the next Enron or WorldCom. But one drawback is that the P/D ratio is useless if a company does not pay a dividend. However, as the chart shows, it has been more accurate than the P/E in identifying significant highs and lows in the S&P 500 Index, for example.

Price/dividend for the S&P 500 Index from 1921 through 2009. The P/D ratio hit a multi-decade low in August 1932 as the stock market was bottoming. Another notable low occurred in September 1982 at the nascent beginning of the 18-year bull market that ended around the P/D peak of nearly 90 in January 2000. We also see the next low in March 2009, after which stocks experienced their next rally. Data courtesy of Dr. Robert Shiller, author of Irrational Exuberance. For illustrative purposes only.

INSIDER BUYS/SELLS. This is a largely misunderstood indicator that many traders attempt to use. Corporate insiders sell stock to raise money for a number of reasons and will sell after the market has been good to lock in profits. For many insiders, selling their stock is an important part of their income. That’s not to say the insider selling should not be tracked. Selling in large caps can be an important signal that a correction may be in the wings, a fact that many investors overlook. And although extremes in insider selling do not necessarily warn of an impending price reversal, they can warn of trouble ahead—both Enron and WorldCom experienced high levels of insider selling before corporate scandals broke.

But to buy their company stock, insiders must trade hard-earned cash, so these signals have provided relatively good buying signals in both bear and bull markets.

[To find insider buying, log on to tdameritrade.com > Research & Stocks. Click on the Reports tab for a list of research provider reports. The last one in the list is from Vickers, which shows an insider trading analysis.]

SHORT INTEREST. This is the amount of stock that has been sold short (stock borrowed and sold in expectation that the price will fall) and is measured as a percentage of a company’s stock float. A company in which 5–20% of the stock has been sold short means that a significant number of investors believe that the price will drop and is often bearish. When short interest rises to 40–50% or more, it can signal a short squeeze—a situation in which the short sellers get squeezed” when stock price rallies as they rush to buy the stock to cover their short positions.

Why is short interest important? Rising short interest is interpreted by many traders as being bearish. But once short interest reaches extreme levels, it has the potential to be a strong contrarian indicator, signaling the stock is getting oversold and may be getting ready to rally.

[To find short interest, log on to tdameritrade.com > Research & Ideas > Stocks. There is a short interest metric on the overview tab as well as the Fundamentals tab.]

Economic Indicators

Stocks perform best when the belief is growing among investors that an economy will mend. And if history is any guide, stocks rally well ahead of solid proof that the economy is getting better. So what are some of the more useful economic indicators in assessing where the economy may be headed?

Traditional economic indicators that might be helpful to shorter-term traders include gross domestic product (GDP), non-farm payrolls jobs, unemployment, the Institute of Supply Management Manufacturing and Service (or Non-Manufacturing) Indexes, personal consumption expenditures (PCE), the producer price index (PPI), the consumer price index (CPI), consumer sentiment, and consumer confidence. [Most of these can be found by logging on to tdameritrade.com and looking under the Research and Ideas, then markets. On the right side, under “Event Calendar”, you’ll find a listing of economic indicators, such as FOMC, PPI, and CPI.]

An interesting and unique measure of economic strength that has proved very useful is the new home market, due to the economic importance it has played in the new millennium. One example is the Philadelphia Housing Index ($HGX), which peaked in July 2005. By the time the S&P 500 Index peaked in late 2007, it had already fallen more than 40%. When a sector as important as housing is getting hit, it can provide a valuable warning that other sectors may be next for those who understand how they work.

In general, although good and bad economic reports have the potential to move markets in the short term, such reports do not often provide reliable stock buy/sell signals. That being said, since an unexpected report can cause an unexpected move in stock price in the near term, such reports cannot be ignored.

Real-Life Indicators

This last segment is titled real-life indicators because they are produced by industry groups to measure real-world supply and demand in key sectors of the economy. These can be quite useful, but are not widely known. It’s important to point out that this list (as well as the list of indicators discussed above, for that matter) is by no means comprehensive.

Our first example is the Baltic Dry Index (BDI). A useful measure of transport demand, the BDI reports shipping rates for dry goods transported by sea. When markets are hot, as they were in early 2008, rates skyrocket. But when markets cool, as they did in late 2008 and early 2009, shipping rates plummet. Since shipping rates are not traded on an exchange, they are for the most part not subject to trader speculation and manipulation. As a result, the BDI can be used as a gauge of real demand for goods and commodities used around the world. That makes it a pretty good economic bellwether.

After hitting a peak of more than 11,000 in May 2008, the BDI dropped rapidly to a low of 663 on December 5, 2008. It has since recovered, and how much it rises will be determined by global supply and demand. Another series of useful real-life indicators is produced by the Association of American Railroads. Below we see a chart of the AAR Rail Traffic Index. Much of our nation’s goods are shipped by rail, and rail car loads provide valuable insight into real supply and demand. [More information on this and other rail indicators is available from the Association of American Railroad.]

FIGURE 2:

Comparison of annual U.S. railcar traffic from 2006 to early 2010. As this chart shows, demand in early 2010 was still well down from 2006 and 2007. The trick is to identify normal seasonal cycles from changes in overall demand. Chart courtesy of AAR.org. For illustrative purposes only.

Putting the Puzzle Together

It’s typically not a good idea to make a stock buying or selling decision based on one indicator alone. There is strength in a decision based on a series of independent indicators. It is also important to remember that what works today will not necessarily work tomorrow, since markets are dynamic and ever-changing.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

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